Where to invest and avoid in 2017

January 11, 2017

When forecasting the year ahead, a safe option for market commentators is to predict more of the same and add a bit of a twist. Although it is human nature to think we live in interesting times where the only constant is change, we also know that in most years progress is incremental.

Peering into 2017, however, I can't help but think that this year really could be different - and, yes, I know that these are the most dangerous words in investment.

Who would have predicted at the beginning of this year that 2016 would see the UK vote to leave the EU and US voters elect Donald Trump as president?

Those political shocks will have a profound influence on financial markets in the months and years ahead. It does feel like markets are at a watershed.

DOUBLE JEOPARDY

There was a significant shift in sentiment on the morning after the US presidential election. Investors initially greeted the unfolding news of Donald Trump's victory by running for cover.

Stock markets fell sharply, while port-in-the-storm assets such as the yen, gold and Treasury bonds attracted buyers desperate for a safe haven. The early reaction was a carbon copy of the response on the morning after the UK's Brexit vote. So far, so normal.

However, while investors took a few days to see the silver lining to the Brexit cloud (a boost for UK exporters and overseas earners from sterling's collapse), there was an abrupt shift to a glass-half-full view of the world just a few hours after the Trump shock.

Equity markets ended the day higher after some sharp swings, while safe havens were quickly dumped as a powerful new risk-on mood took hold.

The surprise result of the US election was quickly viewed as a game-changer in financial markets that would rewrite the rules that have governed investment since the financial crisis.

Time will tell if that is overstating the significance of the regime change, but investors have been unusually decisive in their re-evaluation of what four years of a Trump presidency will mean. A number of themes are emerging.

The first of these is that equities will outperform bonds. Markets are focused on the growth potential of a Trump administration if campaign promises of bold fiscal stimulus come to fruition.

The shift from an era of austerity, during which monetary policy has done the heavy lifting, to a new period of deficit-funded infrastructure spending with less dependence on central bank interventions marks a dramatic change of direction.

More spending, tax cuts and deregulation would provide an equity-friendly backdrop, but the same measures will flash red warning lights for bond investors, because such moves are likely to generate higher debt, a wider budget deficit and inflation.

Fixed-income investors have enjoyed a protracted deflationary ice age that has brought them lower yields and thus higher bond prices during the long, slow recovery from the 2008 crisis.

Talk of an end to a 30-year bull market for bonds is probably overdone, because plenty of uncertainty remains and investor appetite for reliable yields has not evaporated overnight.

CHANGE OF DIRECTION

But money has poured into fixed income in recent years, and equity investors are licking their lips at the prospect of some of those flows changing direction and heading back into shares.

The other themes are related to this new growth narrative. The first is an acceleration in the glacial normalisation of interest rates in the US.

The inability of the US Federal Reserve to build on its first interest rate hike in many years in December 2015 has testified to the power of the 'secular stagnation' story that has dominated investment thinking for many years.

With 'tax and spend' now sharing the burden of stimulus, the Fed will find it easier in 2017 to raise rates. Bond markets have already started to price that in, and over the next year, I expect the dollar to benefit from tighter monetary policy.

This will have a couple of important effects on markets in 2017. First, it supports the argument that developed markets will outperform developing markets. Emerging markets tend to underperform in a strong-dollar environment, as their hard currency debts become harder to service.

Emerging markets are also likely to suffer from a slowdown in trade if protectionist campaign rhetoric translates into a reduction in global free trade.

Secondly, the flip side of a rising dollar will be weakness in the world's other main currencies. A falling yen is good for Japan's dominant export sector, and will help overseas earners in Europe and the UK.

Another theme I expect to dominate investment thinking in 2017 had already emerged before either the Brexit vote or the presidential election, but it was driven by both.

A tendency to adopt populist, growth-focused policies should accelerate the shift from defensive shares in sectors such as consumer staples and utilities towards more economically sensitive, cyclical sectors, including retail and financials.

The investment strategy tipped to shine in 2017

Banks, in particular, stand to gain from a combination of faster growth, deregulation and rising bond yields. They do well when inflation expectations rise and the yields on long-dated bonds increase.

This so-called steeper yield curve is good news for banks, because they borrow at cheap short-term rates and then lend money on to businesses and consumers at higher long-term rates. The difference between the two is their profit margin.

THE US IS KEY

In recent years, the US stock market has consistently outperformed its competitors. I think US leadership will continue next year for a few reasons, despite the relatively high valuations of US shares today.

First, an expected corporate tax cut would boost earnings growth and returns on equity. A promised tax-deal to repatriate perhaps $1 trillion (£0.7 trillion) of profits that US companies have parked offshore would support a surge in takeover activity and capital expenditure.

It would make it easier for US companies to pay higher dividends and buy back their shares.

Elsewhere, arguments can be made for and against all the main regions. In the UK, for example, the pound's fall is a double-edged sword. It makes UK goods and services more attractive in overseas markets, while UK assets look increasingly cheap to foreign buyers.

But the weakness of sterling also threatens to import inflation, cutting real wage growth. Furthermore, two years of painful Brexit negotiations are certain to weigh heavily on business investment and consumer confidence.

Asia also has investment pros and cons. On the face of it, a protectionist US threatens global supply chains, and trade deals such as the Trans-Pacific Partnership are now dead in the water.

However, Asian economies are increasingly benefiting from intra-regional growth as countries develop beyond their former reliance on exports and build more-domestic, demand-driven economic models fuelled by a fast-growing middle class in Asia.

Against this uncertain backdrop, geographical diversification has never looked more sensible. So too has a well-balanced spread of asset classes.

Real estate stands out, after a difficult year in the sector, as a continuing source of both income and portfolio diversification. Commercial property is an attractive investment backed by a real asset with a stable income stream.

Rents remain supported by strong occupier demand and limited supply, after many years of insufficient housing development. In a low-rate environment, a projected total return of 5-6 per cent a year remains compelling.

Commodities will, I suspect, be a mixed bag. A stronger dollar would be a headwind for assets priced in dollars. Industrial commodities in particular face a challenging structural outlook, as the Chinese economy continues to slow and turn from fixed-asset investment.

But one commodity appears to be well underpinned: oil. The oil price has struggled to rally above $50 a barrel, despite bouncing back from a 30-year low of less than $30 in January 2016, but the outlook now looks brighter.

How to play an oil price rally

Opec has clearly tired of its bid to take North American shale oil out of the game by flooding the market with crude and keeping the oil price low.

With global demand steadily increasing, the market looks to be moving back into balance. Don't expect a return to $100 any time soon, but $70 would not surprise me.

So what worries me as I look into my 2017 crystal ball? Frankly, the remarkable unanimity on where the opportunities lie next year - the time to worry is when no one is worried.

Tom Stevenson is investment director for Personal Investing at Fidelity International.

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